Hearing before the Committee on Economic and Monetary Affairs of the European Parliament

Introductory statement by Mario Draghi, Chair of the ESRB
Brussels, 23 September 2013

Madam Chair,

Honourable Members,

It is a pleasure for me to appear before this Committee today in order to inform you about the activities of the European Systemic Risk Board (ESRB). Since we last met, there have been signs of a gradual turnaround in Europe’s economic outlook. While these developments are encouraging, risks to financial stability remain. In my remarks today, I will report on the work the ESRB is undertaking to address some of these risks in the fields of insurance, banking and market infrastructures. I will also report on two other areas of ongoing work: the assessment of the implementation of the ESRB’s first Recommendation and its guidance on the use of macro-prudential instruments to assist national authorities.

Towards a more resilient financial system – a macro-prudential perspective on insurance

The insurance sector plays an important role both in the financial system and in the economy at large. Apart from assuming risks that households or firms do not want to bear themselves, it also acts as an investor. At the same time, there is a need to deal with possible risks and vulnerabilities that stem from insurance, some of which have the potential to affect the stability of the financial system.

Life insurance companies, especially those that promise guaranteed returns, are suffering on account of the current environment of low interest rates. Looking at this from a micro-prudential point of view, EIOPA has correctly advised firms to modify their business models. This is crucial for addressing the issue at its economic source.

If business models are not modified, insurance companies could search for higher yields by investing in riskier assets, but this would expose them to potential losses through increases in risk premia. Firms have limited incentives to address these vulnerabilities if regulatory regimes do not bring them to light. A failure to do so would weaken the sector’s ability to fulfil the important role it has to play in the economy. Spillovers to the wider financial system, through direct linkages and common exposures, cannot be ruled out.

Awareness that the insurance sector may be of systemic relevance has grown. At the international level, the Financial Stability Board has recently announced a list of systemically important global insurers. Five out of nine are European. The International Association of Insurance Supervisors has developed a framework for policy responses, including effective resolution and a higher loss-absorption capacity.

In the United States, systemically important financial institutions – including insurance companies – will become subject to consolidated supervision by the Board of Governors of the Federal Reserve System and to enhanced prudential standards.

In Europe, work to finalise the new system of prudential regulation, Solvency II, is continuing – in this respect, the European Parliament is playing an essential role in its capacity as co-legislator. Solvency II reflects the risk profile of insurers better than Solvency I, and it enhances their risk management capacity. At the same time, the new system should deal with possible unintended consequences of excessive short-term market volatility, including pro-cyclical effects, as the currently debated Long-Term Guarantee Package aims to do. As requested by the European Parliament, the ESRB has participated in the economic assessment of that package undertaken by EIOPA, and supports the main conclusions reached. Given the issues I have just emphasised, it is crucial that this package ensures both adequate capital levels at all times and full transparency of their application. All risks should be addressed appropriately.

Towards a more resilient financial system – a healthier banking system to support the economy

The banking system plays a crucial role in the financing of the economy. At the same time, its role in the unfolding of the financial crisis has highlighted a number of vulnerabilities. Important steps are being taken to address these vulnerabilities, and to deliver the healthier banking system that European citizens deserve – this, too, is an area in which this Parliament has played a major role, approving the regulation on the Single Supervisory Mechanism (SSM).

The forthcoming comprehensive bank assessment conducted by the ECB - conducted in a way consistent with the EBA recommendations announced in March this year – has the potential to strengthen the confidence on the soundness of the banks within the Single Supervisory Mechanism. That, in turn, would reduce banks’ funding costs and lower the cost of credit for firms and households. This requires clear communication, as well as credible and effective ex-ante mechanisms, including fiscal backstops wherever needed, for absorbing any capital shortfalls that such a review might reveal.

At the ESRB, we are looking at two structural features of the European banking system that the financial crisis has highlighted. First, the large size of the banking system relative to the real economy and, second, the concentration of losses in certain lending segments.

In many countries, the rapid growth of bank assets with the support of increased leverage proved to be unsustainable. Once credit losses materialised, some sovereigns that had to support their banking system came under pressure, and deleveraging constrained the extension of credit to the real economy. This amplified the crisis during the downturn and continues to weigh on the recovery. Against this background, the ESRB’s General Board is continuing to reflect on how the size of the banking sector relative to the economy affects the supply of socially beneficially financial services. The Advisory Scientific Committee has likewise started to work on this issue.

During the crisis, banks’ losses were often concentrated in certain lending segments. In a number of countries, losses on property loans have required large-scale public sector intervention in the banking system. But even niche segments such as shipping finance have required intervention in individual banks in some countries. Cyclical sectors to which banks have high exposures in the European Union include construction and property, consumer durables (mainly the automobile industry) and materials and fabrication (mainly the steel and chemical industries). The ESRB is conducting further work in this field.

Towards a more resilient financial system – the role of central counterparties

I will now turn to the role of central counterparties (CCPs), which form a crucial part of the EU’s financial system. As you know, the G20 countries have agreed that all standardised over-the-counter (OTC) derivatives should be cleared through such counterparties. While CCPs offer a number of economic and risk-reducing benefits, they are also becoming systemically relevant nodes in the financial system. This entails a number of macro-prudential risks.

The pro-cyclicality of CCPs’ margin rules and practices is a key concern. Increasing margin requirements in times of stress, and decreasing them in good times, may make sense from the perspective of an individual CCP, but also carries the risk of increasing the cyclical sensitivity of the financial system. These vulnerabilities may grow with the importance of CCPs. While ESMA has already incorporated some helpful provisions into its technical standards, their effectiveness from a macro-prudential perspective might be enhanced through additional mitigating measures of a countercyclical nature.

CCPs also need robust recovery plans and resolution regimes in order to avoid a disorderly insolvency.

Finally, there is also the risk of contagion, particularly across CCPs that clear the same products (under so-called interoperability arrangements). Evolving CCP markets need to be designed in such a manner that limits the spillovers of potential distress at one CCP to another. To this end, specific guidelines have been already issued by ESMA. Nevertheless, given the systemic importance of CCPs, it is important that there is a broad set of tools available to increase their resilience to contagion.

EU legislation has provided the ESRB with a clear role in these areas. For example, under the provisions of the European Market Infrastructure Regulation (EMIR), the ESRB has been asked to examine the potentially exacerbating impact that the pro-cyclicality of margin practices at CCPs may have and to monitor the design of interoperability arrangements. The ESRB considered these issues at its latest General Board meeting, and has commissioned further work.

Ongoing work at the ESRB

Let me also update you on two items of ongoing work: first, the assessment of the implementation of the ESRB’s first Recommendation.

As you know, ESRB recommendations are soft tools, accompanied by an “act or explain” mechanism. Thus, from an accountability perspective, it is important to assess the actions of Member States (including possible explanations for their inaction) after an ESRB recommendation has been issued.

For its first Recommendation – on lending in foreign currency – the ESRB has just completed the first full cycle from the issuance of a recommendation to the assessment of its implementation. As you may remember, the Recommendation sets out a series of measures to tackle possible systemic risks of lending in foreign currency to the non-financial private sector. The ESRB’s General Board is in the process of finalising its assessment, which will be published in the next few weeks, and looks forward to applying a similar procedure to the next assessments of ESRB recommendations.

The second item relates to the guidance on the use of the macro-prudential instruments provided for in the recently approved European capital rules (CRD IV/CRR).

As you know, the new European capital rules will start entering into force in 2014. They provide for a range of macro-prudential instruments that national authorities will be able to deploy. As I mentioned to you at my previous hearing on 8 July, the ESRB is working with Member States on guidance on how national authorities can use these instruments in a coordinated manner. I will provide you with more details on this matter at the next hearing.

Thank you very much for your attention. I am now available for questions.